Abstract
The paper shows that politically motivated interventions in the financial market in the form of bailing out borrowing firms reduce banks' incentives to gather valuable information about firms' projects. This loss of information is a hidden cost which adversely affects firm value. Firms invest resources and pay a premium to politically connected persons (BOD or other personnel). Such connections serve the twin purposes of hedging and enhancement of the value of collateral pledged against bank loans. Feeling secured, banks lose incentives to monitor borrowing firms. Thus, wealth effect of bailout from political connection is partially offset by the losses of valuable information brought about by bank lending. In equilibrium, the trade-off from gains out of political connections and costs due to losses from information-based bank monitoring depend on (i) the country's disclosure laws, (ii) the political environment, (iii) the premium paid to form connections, and (iv) the state of the economy.
•Firms build up political connections by paying premium to politically connected individuals to obtain bailout during financial distress.•The wealth effect for firm from such bailout is partially offset by decline in information based bank lending.•Decline in the quality of banking services from politically motivated intervention thus imposes hidden cost to economy.•The magnitude of costs is higher for economies with state owned banks or inadequate disclosure laws.